Mainstream economist discovers that banks create money (Krugman vs. Keen continued)

If you don’t realise something is broken, how do you know you need to fix it? One of the major problems monetary reformers face is that by and large the economics profession does not understand money and banking. This leads to them giving bad advice to policymakers, with bad policy leads to bad outcomes for everyone.

The reason that money is misunderstood is partly down to Adam Smith’s book, The Wealth of Nations. Smith essentially popularised the view that money naturally emerged from barter. As barter was inconvenient, so the story goes, people began to switch to using things which the majority found valuable, would accept in exchange for their goods and was easily divisible.

Gold and silver therefore naturally emerged as currency, and over time governments began minting coins in order to ensure the coins held the amount of gold they claimed to. Eventually the precious metal content was removed by governments in order to gain a source of revenue, yet the trust in the coins remained and they continued to be used by the people.

This ‘historical’ story leads to a view of money as merely a token which people use to transact with each other. In this view money is simply a veil over barter – emerging out of convenience. As such it has no economic effect other than to ‘oil the wheels’ of trade. With money economically insignificant, economists can then go about their work safely ignoring the role of banks, money, and debt.

However, if rather than coming out of barter relations money originated as a debt-credit relationship (see David Graeber’s ‘Debt, the first 5000 years’ for an explanation) the creation of money would have real economic affects. In the modern world banks have created almost all money as debt, yet the majority of economists are still stuck with their view of money as a veil over barter, and so see no need to think about money, banks or debt.

A good example of this can be found in the ongoing debate between Paul Krugman and Steve Keen.

Paul Krugman was the 2008 Nobel Laureate in Economic Sciences “for his analysis of trade patterns and location of economic activity”.

Steve Keen is Professor of Economics & Finance at the University of Western Sydney, and author of the popular book Debunking Economics.

It all started with a paper by Steve Keen on Hyman Minsky, an American economist who well understood that banks can create money and saw this as an inherent cause of instability in the economy.

In this paper Steve Keen criticised a paper by Krugman which attempted to model Minsky’s ‘Financial Instability Hypothesis’ without incorporating the central tenet that banks create money.

Krugman responded to the criticism by writing a blog which claimed that banks don’t really create money, by explaining that in the economics textbook version of banking banks don’t create money.

And then posted a second after almost all of the commenters pointed out how wrong he was.

And then a third.

To which Keen replied here, and then posted again here.

Several other economists and commentators have got involved on Keen’s side, including Steve Roth, Randall Wray and Scott Fullwiler.

What is great about this is that those economists who don’t understand how banks work are finally being taken to task by the people who comment on their blogs. An understanding of what banks actually do is coming to light, and as long as economists like Krugman are big enough to admit that they might have got something wrong, we might begin to see more economists treating banks and money in a realistic manner.

Once this happens the ability to push for monetary reform will be greatly enhanced – at the moment the economists to whom governments turn for advice on fixing the banks don’t understand what banks do and so don’t see a problem. Of course, when they do understand what banks do they might still not see a problem, but at least we will all be singing off the same hymn sheet, which is a start.